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Bocconi University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

August 16, 2012

Abstract:

This paper studies whether fiscal corrections cause large output losses. We find that it matters crucially how the fiscal correction occurs. Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions. The difference cannot be explained by different monetary policies during the two types of adjustments. Studying the effects of multi-year fiscal plans rather than individual shifts in fiscal variables we make progress on question of anticipated versus unanticipated policy shifts: we find that the correlation between unanticipated and anticipated shifts in taxes and spending is heterogeneous across countries, suggesting that the degree of persistence of fiscal corrections varies. Estimating the effects of fiscal plans, rather than individual fiscal shocks, we obtain much more precise estimates of tax and spending multipliers.